1. Increase in Japan's Foreign Direct Investment in East Asia

Following the sharp appreciation of the yen after the Plaza Agreement of September
1985, Japan's foreign direct investment (FDI) in East Asian countries increased
rapidly: from around $US1 billion during the first half of the 1980s, it started
to increase sharply in 1986 and hit a peak of around $US8 billion in 1989.
This rapid increase then stopped as the appreciation of the yen slowed during
1990–92, although the level has stayed around
$US6–7 billion (Figure 1). However, it should also be noted
that Japan's total FDI has increased significantly since 1986, and that
East Asia has not necessarily been the major investment destination for Japan
(Figure 2).

The main factors that have driven this rapid increase in Japan's FDI in East
Asia can be summarised as follows:

the appreciation of the yen;

the aggravation of trade friction;

lower wages in East Asian countries; and

imports from East Asian countries.

The appreciation of the yen after the Plaza Agreement was regarded as irreversible
by most Japanese firms and, since corporate ability to maintain export volumes
by squeezing profits was thought to be very limited, firms tended to respond
by effecting structural changes to improve their competitiveness in international
markets, including shifting production overseas.

In spite of the sharp appreciation of the yen, Japan's trade surplus did not
decrease significantly until 1988, which further aggravated trade friction.
Voluntary export restrictions
vis-à-vis the United States and EC countries were introduced
or strengthened in certain areas (automobiles, machinery etc.). In some cases,
anti-dumping duties were imposed on Japanese exports. These restrictions on
exports also prompted Japanese firms to shift production out of Japan. While
some (mainly automakers) shifted production directly to North America and Europe,
others chose to set up production sites in East Asian countries from which
to export to the United States and Europe.

For most Japanese firms that have chosen to invest in East Asia, the main reason
to shift their production was, at least initially, to take advantage of lower
wages in these countries so as to improve their competitiveness in international
markets. For example, in 1986, average real wage costs in newly industrialising
economies (NIEs) were only slightly more than 20 per cent (and in ASEAN countries
less than 10 per cent) of the figure for Japan.

While most of the components were, at least initially, exported from Japan, the assembly
process, which is relatively labour intensive, was shifted to low-wage countries
in East Asia. This kind of production shift to
East Asian countries can be thought of as a typical example of the most
important structural response to the appreciation of the yen – that is,
restructuring domestic production to specialise in high-value-added products.
Similar to high-value-added final goods, certain components which require a
high level of technology and a well-trained workforce remained competitive
in spite of the sharp appreciation of the yen, as there were few competing
producers. These components, therefore, could be, and in fact had to be, produced
domestically. On the other hand, the assembly process, which does not necessarily
need such high technology, nor such skilled workers, could be shifted to countries
where wages were lower so as to improve the price competitiveness of the final
product.

Whilst initially the main purpose for Japanese firms to invest in East Asian countries
was to improve their competitiveness in international markets, as this shift
proceeded, Japanese firms started to import certain products from their production
sites in East Asia (Figure 3). This was especially the case for low-value-added
or ‘lower-end’ goods. For these goods, competition in the domestic
market is also high, and firms have tried to become more competitive by importing
from their affiliates in East Asian countries where production costs are lower.
In fact, in recent years, importing from overseas affiliates has been cited
by a number of firms as one of the main reasons for undertaking FDI, especially
in East Asia. For example, according to the survey published by the Export-Import
Bank of Japan, more than 20 per cent of firms which invested in ASEAN countries
in 1993 raised this reason; the corresponding figure being around 20 per cent
in the case of China, and 12 per cent for NIEs.

2. The Influence of Foreign Direct Investment in East Asian Countries

As suggested by Figure 4, from the viewpoint of recipient East Asian countries, movements
in the inflow of foreign direct investment can be classified into the following
three stages:

Investment in NIEs first increased during 1986–89. This was mainly because
these economies provided a reasonably good environment for foreign investment
in terms of infrastructure, level of education, institutional framework and
political stability.

Second, investment in ASEAN countries increased during 1988–90. This was because,
by then, the wage level in NIEs had increased significantly, reflecting their
own rapid growth (that is, the benefit of lower wage costs had largely been
lost in NIEs). Even NIE firms started to invest in ASEAN countries as they
gradually lost their competitiveness due to higher domestic labour costs as
well as exchange rate changes
vis-à-vis the US dollar.

Since 1990, investment in China has grown dramatically in line with the opening up
of its economy.

The share of Japan's investment in total FDI received by these economies has
been around 30 per cent in NIEs and around 20 per cent in ASEAN countries.
In the case of China, Hong Kong occupies by far the largest share, but this
is because foreign investments, including those from Japan and the United States,
made through affiliates in Hong Kong are included.

This rapid increase in FDI has had a significant impact on East Asian countries,
not only economically but also socially. The scope of this paper, however,
is limited to economic effects, which can be classified into three areas, namely:
supply capacity, foreign trade and domestic demand.

2.1 Influence of FDI on Supply Capacity

The increase in FDI has influenced the supply capacity of recipient countries by
effecting shifts in industrial structure, increasing labour productivity and
contributing to production technology.

During the 1980s, in most East Asian countries, the primary sector decreased as a
share of GDP while the secondary and tertiary sectors grew (Figure 5).
This kind of change in industrial structure is, of course, seen in many industrialising
countries, and it is not clear to what extent it can be attributed to the increase
in FDI.
Figure 6 indicates the relationship between shifts in industrial structure
and the increase in FDI for Malaysia and Indonesia, where relevant annual data
are available. It can be seen from this figure that the shift in industrial
structure has taken place broadly in accordance with the increase in FDI, which
suggests that FDI has played a significant role in changing industrial structure
in these countries. It seems likely that this has also been the case in most
other counties, although data availability is too limited to present clear
evidence.

In the case of NIEs, the increase in the share of the secondary sector had halted
by the mid 1980s and, in fact, the share has slightly fallen since 1985. This
might be because the tertiary sector has been growing more rapidly in line
with the growth of consumption in these economies, as argued later.

Labour productivity, measured in terms of real GDP per worker, has been on a steady
increase in most East Asian countries since the 1980s (Figure 7). Although,
again, it is not clear to what extent FDI has contributed to this improvement,
in most ASEAN countries (except the Philippines) it seems to have played a
major role. This is suggested by the fact that the acceleration of labour productivity
has coincided with the rapid increase in FDI, and that the share of FDI in
aggregate domestic investment remains at an extremely high level. Comparing
the development of the capital equipment ratio with FDI in Thailand and the
Republic of Korea (for which statistics are available), there is a clear sign
of labour productivity improvement in Thailand in the second half of the 1980s,
with FDI serving as a locomotive enhancing the ratio. In the Republic of Korea
also, developments in the capital equipment ratio generally coincide with those
of FDI received (Figure 8).

The increase in FDI is expected to contribute to the progress of production technology
in recipient countries (technology transfer). This effect is very difficult
to quantify. It could, for example, be guessed from the increase in the share
of industrial products in total exports and the increase in exports to industrial
countries (Figures 9
and 10),
which will be mentioned later. It is, however, often argued that those exports are
still produced by the affiliates of firms from Japan and other industrial countries.
Thus the extent to which the technology has been well transplanted in recipient
countries might be questionable.

2.2 Influence of FDI on Foreign Trade

In accordance with the shifts in the industrial structure induced by the increase
in FDI in East Asian countries, the structure of their exports has changed
gradually. The share of industrial products in total exports has grown significantly
since the mid 1980s and the share of primary products has decreased (Figure 9).
This change is supposed to have contributed to making their export earnings
less sensitive to movements in commodity prices, which has laid a solid basis
for their stable growth.

The contribution of net exports to their growth, however, has remained fairly limited,
because their imports have also increased broadly in line with exports (Figure 10).
This increase in imports can be mostly attributed to the import of capital
goods and intermediate goods (various components) associated with FDI. It should,
however, be noted that, without the expansion of their export market induced
by the shift in their export structure, the increase in their imports of capital
goods would not have been possible, which would have significantly limited
their economic growth.

In addition, because of the change in the export and import structure in each country
induced by the increase in FDI, regional trade flows have changed significantly
(Figure 11). For example, the value of trade (exports plus imports) between
the United States and NIEs doubled between 1985 and 1992, and that between
Japan and NIEs tripled, at least partly reflecting ‘indirect’ exports
from Japan to the United States through NIEs. A similar pattern is also observed
for ASEAN countries. Furthermore, the expansion of inter-regional trade flows
among NIEs, ASEAN countries and China, is also significant. This expansion
of inter-regional trade seems to reflect strengthening of mutual economic ties,
especially the establishment of the horizontal division of production among
those countries, which has gradually grown as a result of the increase in FDI.

2.3 Influence on Domestic Demand

The increase in FDI, combined with domestic investments induced by FDI, seems to
have resulted in an expansion of job opportunities in East Asian countries,
which has contributed to a rise in personal income, and hence personal consumption.
The increase in domestic demand induced by FDI through this channel is likely
to have also supported the high growth enjoyed by East Asian countries in recent
years. In fact, parallel increases in FDI, labour income and personal consumption
can be observed in NIEs, ASEAN countries, and China (Figure 12).

3. Influence of the Increase in Foreign Direct Investment on Japan's Trade
Structure

The rapid increase in Japan's FDI has also affected Japan's own trade structure.
Noteworthy is that while the share of Japan's FDI in East Asia is not so
large compared with Japan's total FDI, its influence has played a significant
role in changing Japan's trade structure.

First, the rise in FDI has resulted in an increase in so-called ‘induced’
exports. At the initial stage of overseas production, capital goods (mainly
production equipment) are usually exported from Japan. Then, once production
has started, many components for production are exported. In fact, a significant
increase in exports to overseas subsidiaries has been observed in line with
the increase in FDI (Figure 13). This increase in induced exports has
been particularly significant in the case of FDI in East Asian countries because
the supply of capital and intermediate goods has been very limited in these
countries. An increase in induced exports is expected to lower the price elasticity
of Japan's exports, because induced exports tend to respond less to exchange
rate fluctuations.

Second, as stated before, restructuring of domestic production has taken place in
accordance with the increase in FDI, so that domestic production has come to
be more specialised in high-value-added goods. These high-value-added goods
are often technology intensive, and hence exhibit strong non-price competitiveness.
Export of these goods, therefore, tends to be less sensitive to changes in
the exchange rate, resulting in the lower price elasticity of Japan's exports.

As a result of the two above-mentioned factors, Japan's export volume is expected
to have become less elastic to changes in the exchange rate. In fact, the elasticity
of Japan's export volume to the relative price factor is found to have
decreased significantly for the estimation period after the Plaza Agreement
(see Table 1 results for
1986–92).[1]

Table 1: Parameters of Export Volume Equations

Estimation period

Income factor

Relative price factor

1975:1 – 1985:4

1.75

−1.53

1986:1 – 1992:3

0.50

−0.62

Third, on the import side, the shift of production of low-value-added or ‘lower-end’
products overseas, associated with the increase in FDI, has resulted in an
increase in imports from Japanese firms' overseas affiliates. This, again,
has been particularly the case for FDI in East Asian countries because the
shift of production of this category of goods has been mainly directed to these
countries where the advantage of lower wages is larger.

For individual firms, this shift has meant the establishment of the horizontal division
of production between domestic factories and those overseas. Once this division
has been established as a result of FDI and importing from overseas affiliates
has commenced, the existence of ‘sunk costs’ tends to prevent frequent
adjustment in such imports. For example, import volumes are less likely to
decrease immediately even when the yen depreciates. In other words, at least
some of the influence of exchange rate changes can be absorbed by each individual
firm in terms of the reallocation of profit between head office and overseas
subsidiaries. This could be a possible factor reducing the elasticity of Japan's
imports to exchange rate changes.

In fact, the price elasticity of Japan's import volume seems to have fallen slightly
(from −0.33 to −0.26) since the Plaza Agreement (Table 2),
although it is questionable whether or not this fall is statistically significant.
Taking account of the fact that this observed fall during 1986–92 took
place against the background of various structural measures to promote imports,
it seems that the influence of the increase in FDI on Japan's imports has,
in fact, been significant.

Table 2: Parameters of Import Volume Equations

Estimation period

Income factor

Relative price factor

1975:1 – 1985:4

0.88

−0.33

1986:1 – 1992:3

1.04

−0.26

In conclusion, it is likely that these changes in Japan's trade structure induced
by the increase in FDI have made Japan's trade balance less sensitive to
exchange rate changes. It is, therefore, possible that changes in the exchange
rate have become less effective in adjusting the trade imbalance as a result
of the increase in FDI.

Footnotes

The views expressed are those of the author and do not necessarily reflect those
of the
Bank of Japan.[*]

It should be noted that structural changes took place continuously during the estimation
period, and hence the estimated parameters could be different from those
to be obtained after all the changes have been completed. This is also the
case for Table 2, where the results seem more puzzling.
[1]